Any hopes of easing into the new year were swiftly dashed, as concerns around inflation re-emerged, leading to a spike in volatility in bond and currency markets. While the sell-off in bonds was global in nature, the UK was hit particularly hard, which will make for unpleasant reading for the Chancellor, Rachel Reeves.
UK government bond yields have been steadily rising over December and spiked this week, with longer-dated bonds selling off the most. This now means long-term borrowing costs for the UK are now at levels not seen since 1998. It seems the sell-off has been driven by dual concerns around sticky inflation and slowing economic growth. The market now only expects the Bank of England (BoE) to cut rates twice this year (due to inflation) and there are also expectations of lower tax revenues due to lacklustre growth. For the Chancellor, there is a now a risk that she will breach her own fiscal rules, and this could lead to either further tax increases or spending cuts, in order to help balance the books. Sterling fell in tandem with government bonds this week, falling to a 14-month low versus the US Dollar. UK large cap equities actually rallied during the week, most likely in reaction to the lower currency, which should boost overseas earnings (when translated back to sterling). The mid-cap index, which is typically more domestically focused, dropped close to 2% on Wednesday, led by consumer stocks. If interest rates stay higher-for-longer, there will likely be a negative impact on the consumer (in part due to higher mortgage rates), who could see disposable incomes dented.
On Monday there were reports that Donald Trump and his team were considering scaling back their tariff plans, however, this was quickly dismissed with Trump tweeting this was “fake news”, causing equity markets to wobble on Monday afternoon. The market views tariffs as an inflationary policy and this has helped to push inflation expectations higher in the US, forcing US government bonds to sell-off this week, approaching levels not seen since November 2023.
With inflation concerns once again coming to the fore, there has been a different equity market leadership in 2025 compared to 2024. Sectors such as oil and gas, mining and financials have led the way, sectors that feature prominently in UK indices, but are light in US indices, which are heavily exposed to technology. If inflation concerns persist, then investors will need to consider their asset allocation. In 2022, when we saw inflation and interest rates rise, the UK large cap index outperformed the US equity index by a staggering 29%. At this juncture, we think diversification in portfolios is important, with inflation strategies, such as resources and gold included in the asset mix.
Inflation is certainly not a concern in Switzerland where prices fell over the month of December and headline inflation is a meagre 0.6%. This low level of inflation has allowed the central bank to cut rates to 0.5%. Deflation seems the biggest concern in the world’s second largest economy, China, with the latest inflation print at 0.1%. There are real concerns that China is going down the same path as Japan did 30 years ago, with similarities being made due to demographics, an ailing property sector and elevated private debt levels. The concerns have led to Chinese equities falling over 5% in 2025.
The gold price proved resilient throughout the weak, despite the increase in real yields. It is back approaching $2,700 an ounce, close to its all-time high. As commented on last week, oil has been moving higher in 2025. Brent crude oil is approaching $80 a barrel and this will feed into the upcoming inflation data.
The week finished with the most important economic data, the US Non-Farm Payrolls data, which showed 256,000 jobs had been added to the economy, while unemployment dropped to 4.1%. Both data points beat expectations, leading to investors believing the US economy is strong, and that the US Fed will likely be very slow and steady in future rate cuts. US government bonds sold off on the news, and US equities look like they will open lower.
The mood music has changed so far in 2025, inflation concerns have bubbled to the surface and the optimism of deep rate cuts in 2025 has diminished. Within the portfolios exposure to resources, which struggled in 2024, are now leading the way, highlighting the benefits of diversification and blending holdings that perform in different environments.
Andy Triggs, Head of Investments
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